1.7 The Natural and Market Price of Commodities
In periods when a market is stable, the prices of goods gravitate toward a level that Smith considers to be "natural" pricing - in that price demanded for a good reflects the cost of producing it. Natural pricing is good in that it removes risk to both buyer and seller of any good (including production goods and labor) - so an item can be sold for precisely what its worth because the supplier does not need to charge more to mitigate his risk of "loss by trade" due to market fluctuations in prices.
Supply and Demand
The "market price" meanwhile has little to do with the costs of production. While a seller may consider his costs in asking a price, the buyer considers his need for an items in the context of his need for all items, his stock of money to trade to obtain these items, and the price that might be paid to other suppliers to the same item. The seller must negotiate with the buyer to agree upon a price of trade - and whether this is equal to, higher than, or lower than the "natural" price is purely coincidental.
Smith considers supply and demand in the aggregate. When there are more buyers than sellers of a good, buyers "bid up" the price such that those who are willing to pay the most will obtain the good. When there are more sellers and buyers, sellers must reduce the price, and the sellers willing to charge the least will obtain the most business. Thus, the quantity of goods supplied and demanded are greater determinants of market price than the costs of production.
It is only in the situation, which is an unlikely coincidence, that suppliers furnish the exact quantity that buyers wish to obtain, that the market price and natural price of goods are likely to coincide.
Risk of Time
In addition to the fluctuations of supply and demand, the risk to suippliers in a market is compounded by the effects of time. In a basic sense, the supplier of a good must undertake expenses in advance to produce a good, some time is involved in the act of production. Later, when the goods are finished and taken to market, there is the risk he will get less than their value due to changes in the "market price" that is driven by supply and demand for goods.
Not only does the supplier pay a fixed price to obtain materials and supplies, but he also enters into a contract with employees to pay a fixed amount for their labor. He also bears the risk that he will pay more to replenish his stock of materials for future production.
Additionally, the supplier must plan in advance what quantity of goods to produce (or procure from producers) without a perfect knowledge of the quantity that will be demanded when he takes the goods to market in future.
As such, each supplier is inclined to demand prices above his costs to compensate himself for these risks. Done on the scale of the entire market, all suppliers are constantly charging inflated costs for all goods to mitigate their risk, and the problem is exacerbated.
Fluctuations in Supply and Demand
In some industries, there can be significant fluctuations from one time period to the next in the amount that can be produced for reasons beyond the control of the producer. A farmer may have a good or bad season that results in more or less crop output, a shepherd's flock may suffer a disease or an unexpected increase in the number of calves, a miner may encounter a rich vein of ore or find himself boring through barren rock.
This generally occurs on the very basic level of raw materials, but it ripples through the economy: a drought decreases the output of grapes which decreases the production of wine, a miner who strikes a lode of iron ore yields an abundance of metal for the production of numerous goods. In agricultural products, specifically, a single environmental event such as a drought decreases production of all agricultural goods.
Other factors may be the cause of the actions of others: the operator of a cotton mill has no control over whether another person chooses to open a new mill, or an existing producer goes out of business, and the aggregate supply of cloth to the market increases or decreases as a result.
And not only is the aggregate supply of goods influenced, but the aggregate demand is influenced as well. A farmer who has a bumper crop hires more field hands, or releases from employment workers in time of drought. The opening or closing of a substantial business, such as a factory, affects not only the income of existing residents but shifts the population, as workers will move into an area where there is the promise of employment, or leave an area when there is greater need for them elsewhere. Thence, by the increase of consumer income and number of consumers, arise fluctuations of the quantity of demand in local markets.
Such fluctuations impact the supply and demand for goods in a market, both as an immediate consequence and over the long-term, as producers plan their level of output to their expectations. These fluctuations may be sudden or gradual, their duration temporary or long-term, their impact great or small. And much of this defies accurate prediction.
Variance in Supply
Similar to the notions above, though largely specific to production and in the longer term, are variances in supply due to location-specific factors. For example, the vineyards of France produce more grapes, of higher quality, than vineyards elsewhere in Europe. This is not a short-term and unpredictable effect such as a drought, but a long-term and entirely estimable consequence of geography.
The variance in supply affects the quantity and quality of goods in local markets, proximate to the point of origin, but is also germane to the demand for goods in international trade. Because the wines of France are so good and so plentiful, consumers in England can enjoy a higher quality at a lower price, and there is little sense in producing wine domestically.
(EN: In Smith's time, this would have been of particular interest - with supplies among nations constantly fluctuating due to political strife and the emergence "new" supplies of goods from freshly-established colonies. Now that the world is largely settled and largely at peace, the sudden variances caused by new producers in new locations is mitigated - it still happens, but the percentage of "new" as opposed to established trade is significantly less.)
Competition
Where a market involves multiple producers of the same good, there is competition among them for the buyers that has a general tendency to drive prices downward. Though no supplier can lower prices to less than the costs of production, producers must undertake the effort to price items as low as it is possible, sacrificing profit-per-unit for profit in aggregate.
The net result is that the most efficient producer gains the greatest share of business by offering to the market the lowest price. Producers who cannot match this price, and who exhaust the number of buyers who are willing to pay a higher price for their goods, go out of business. This resets the quantity supplied to the market is decreased and the price of goods rise.
On the other hand, when demand exceeds supply, producers have no such pressure to decrease prices and instead seek to increase price-per-unit and reduce production to achieve the greatest profit in aggregate. During such times, producers enjoy high profit margins on their goods.
The corresponding result is that the profitability of a given line of business attracts other producers, increasing the supply to the market and hence decreasing the price of goods.
Ultimately, an unregulated market drifts toward equilibrium, the point at which market prices match natural prices, such that buyers pay exactly the "right" amount for a good to encourage sellers to produce at the exactly the "right" quantity to meet their aggregate demand.
Trade Secrets
One of the means of competition among producers is to attempt to discover methods by which goods can be produced more efficiently. In order to gain an advantage over competitors, a producer must keep secret any method he discovers of doing so - as if his rivals were able to employ the same methodology, it would no longer be an advantage to that specific producer.
(EN: The author does not consider the "trade secrets" that pertain not to efficiency of production, but quality of output. But given the era, goods were scarce, such that consumers were happy to have cloth at all and did not have much to choose from in the way of different grades or qualities from different producers.)
In Smith's time, it was reckoned that secrets in manufacturing could be kept for longer than secrets in trade, due to the scarcity of factories. The separation of hundreds of miles made it difficult for the operator of one factory to observe the operations of another, or to hire the workers who have first-hand experience in other operations and thus gain access to their trade secrets.
(EN: This too has changed over time, especially in the last quarter of the twentieth century, when employers became less interested in retaining workers for the long run, and as a result people move from one employer to the next, taking with them the "trade secrets" of their former employers. In the present day, differences in operations are seldom the result of "secrets" so much as they are of strategy - a producer is well aware of what his competition is doing, but chooses to adopt or disregard practices based on his assessment of how they fit his own firm's strategy.)
Market Restrictions
Free competition results in the maximum supply of goods at the lowest prices to the market, an enables producers to seek the most profitable employment of their resources, and workers to seek the best wages for their effort. Historically, every effort to interfere with the ability of producers and workers to choose for themselves the most productive course of action has resulted in greater harm than good to the general population.
Whenever a state has granted a monopoly to an individual or company, the effect has been that the market is constantly under-supplied and the good in question is kept greatly above its natural rate. Laws that likewise restrain competition by granting privilege or license to a small number of producers have a similar effect: a profit to a small number of privileged producers to the detriment of all consumers. Laws that limit the amount that it is permissible to produce similarly create an artificial shortage of goods.
Laws that attempt to fix the price of a consumer good, rather than the quantity of producers or product, also result in a shortage of goods, as the price is generally fixed to a level at which producers cannot earn sufficient profit, eventually even sufficient revenue to sustain their operations, and new producers have no incentive to enter the market.
Laws that attempt to fix the price of a production good likewise discourage production. Laws fixing the wages of workers are of particular interest, as this creates a situation in which the costs, rather than the revenue, of production are increased, increasing the cost of the good, decreasing market demand.
Conclusion
Smith stops abruptly, stating "this is all I think necessary to be observed" about the factors influencing the price of goods. He does add, however, that the price of goods itself does not determine the wealth of nations - it may increase or decrease the nominal amount of money one earns and pays for things, but ultimately not the quantity of goods that can be had to satisfy the necessities and conveniences of life, which is ultimately the measure of prosperity in any society.